Topic 1 (Pt2) - Intro to Financial Markets

Question 1

How to calculate monetary returns?

Answer 1

Profit = Dividends + Capital gains

      = Div1 + (P1-P0)

Question 2

What are the different ways return can be expressed?

Answer 2

1. Monetary returns (cash returns)
2. As a percentage
3. As a decimal

Question 3

How to calculate returns as a percentage?

Answer 3

(Div1/P0 + (P1-P0)/P0)) x 100

Question 4

What does the mean give?

Answer 4

An average over a period of time

Question 5

What is variance?

Answer 5

• Variance measures spread from the mean
• This volatility provides an indication of the risk an investor may be exposed to when purchasing an asset
• Large variance = large deviations from the mean

Question 6

Formula for variance

Answer 6

1/T sum of (r-mean)^2

Question 7

What is the probability theory?

Answer 7

Where a crisis is an accumulation of little shocks that didn’t all happen at once. We can calculate the probability of those shocks occurring

Question 8

What does the probability theory assume?

Answer 8

Probability theory assumes that
variables are normally distributed

But random variables have a habit of not behaving that way,
especially in finance.

The normal distribution underestimates the probability of extreme values, both positive and negative. Crisis indicates our failure to consider these outliers

Question 9

What properties should stock prices have in an “Efficient” market?

Answer 9

1. random, unpredictable
2. prices should react quickly, correctly and fully to news
3. Investors cannot earn abnormal, risk-adjusted returns

Question 10

What newly available information can affect the firm?

Answer 10

Global climate, state of the economy, firm health

Question 11

What does more volatile returns mean?

Answer 11

The more volatile returns, the more unpredictable future returns are, and the greater the risk (upside/downside).

Question 12

What causes asset price volatility?

Answer 12

1. Natural disasters, demand and supply conditions, inflation ….
2. Fear and panic - mass buying and selling that isn’t driven by market conditions

Question 13

What are 3 things to consider when looking into stock market efficiency?

Answer 13

1. Magnitude issue
2. Selection bias
3. Lucky event issue

Question 14

What are 3 things to consider when looking into stock market efficiency (MAGNITUDE ISSUE)?

Answer 14

Only managers of large portfolios can earn enough trading profit from mispricing.
◦ Hence it is investment managers whose trades drive stock prices towards their fair price.

Question 15

What are 3 things to consider when looking into stock market efficiency (SELECTION BIAS)?

Answer 15

Those that have discovered investment strategies that generate
abnormal returns are unlikely to share them

Question 16

What are 3 things to consider when looking into stock market efficiency (LUCKY EVENT ISSUE)?

Answer 16

Some investors will be lucky-‘winners’

Question 17

What are financial returns?

Answer 17

We can expect to earn a certain amount for holding an asset, however the actual return can be lower/higher than this expectation.

The expectation could be based on average past return or using the firm prospects.

Monetary returns take into account dividend income and capital gains.

GIVE FORMULA and annotate that dividends could be zero and capital gains can be negative

Question 18

Summarise Risk and return

Answer 18

Average return over a period provides an indication of past performance and thus potential future performance.
FORMULA FOR MEAN

The variance of an asset’s return shows the spread of returns from its mean, and thus provides a measure of volatility and therefore risk, with higher variances indicating greater volatility
FORMULA FOR VARIANCE

Question 19

Systematic risk aka market risk

Answer 19

1. This comes from the entire market, and affects all assets in that market.
   For this reason, this risk cannot be reduced by simply holding a diversified portfolio

EXAMPLES: natural disasters, economic crisis, wars

Different assets may be affected differently, with some sectors affected more adversely than others, but the entire market feels the impact